Remarks by Governor Edward M. Gramlich
At the National Savings Forum, Washington, D.C.
June 20, 2001

Saving by Low- and Moderate-Income Households

In the past I have talked about how important it is for the nation to increase its overall level of saving, to provide funds for capital investment and associated productivity gains. Today I want to switch gears and talk about how important it is for individuals to save, focusing particularly on low- and moderate-income households. In the process I will summarize some important lessons from recent research, largely done at the Federal Reserve.

Saving can be difficult, but it is vital to the financial security and future living standards of individuals and families. For low- and moderate-income households, it can be particularly difficult to set aside funds for the future. Households of modest means have barely enough money to meet their day-to-day needs, and may not have access to programs that subsidize saving, such as employer-provided pensions. They may also be relatively untutored in financial matters.

From the Flow of Funds Accounts produced by the Fed, we know that overall household wealth nearly doubled over the past decade, from less than $21 trillion at the end of 1990 to about $40 trillion at the beginning of this year. By definition, this gain in household wealth can be decomposed into its two sources: capital gains and saving. About 80 percent of the increase in wealth over the past decade was attributable to capital gains, only 20 percent to saving. A large portion of household capital gains was in turn due to the strong performance of the stock market. But households also saw increases in the value of some other assets; in particular the value of their houses increased by about 50 percent.

To disaggregate this total by income group, we need to look at the Survey of Consumer Finances (SCF), a survey of about 4,000 households that has been undertaken by the Fed every three years since 1983. As you will see, this survey produces, and has produced, very important information on the financial circumstances of different types of households. Surveys are going into the field again this month and, if I could be forgiven a bit of advertising, we hope you will be willing to participate if asked.

The SCF shows that as a general matter, low- and moderate-income households did not fully participate in this phenomenal gain in overall wealth. To share in the wealth created by the stock market boom, a household had to own some stocks. Unfortunately, low- and moderate-income households own relatively few financial assets, and even fewer stocks. The most recent SCF indicates that the typical low-income household--defined here as having an annual income of less than $10,000--had only a little more than $1,000 in financial assets; and the typical moderate-income household--a household with income between $10,000 and $25,000--had less than $5,000 in financial assets. Moreover, what little they had was often invested in liquid form, such as checking accounts, that provide only interest returns, not capital gains.

Participation in the stock market has become significantly broader over the past decade. About 50 percent of all households currently own stocks either directly or indirectly through a mutual fund or retirement account. But less than 25 percent of moderate-income households, and less than 10 percent of low-income households, own stocks directly or indirectly.

On a brighter note, the stock ownership rates for low- and moderate-income households are beginning to pick up. Ownership rates in 1998 were about two and a half times greater than they were in 1989, when virtually no low-income households held stock and only 13 percent of moderate-income households held stock. Even though they still lag far behind the ownership rates of higher-income households, stock ownership rates have been rising for low-income households at a faster rate than for higher-income households. This means that wealth disparities could start to narrow as low- and moderate-income households begin to participate in the processes that have greatly improved living standards for high-income households.

Low- and moderate-income households also have been poorly positioned to benefit from the rise in house prices over the past decade. Two-thirds of all American households now own their own homes, but only about one-third of low-income households and a little more than half of moderate-income households do. These lower homeownership rates in large part reflect the difficulty faced by households of moderate means in saving for the down payment necessary to get a mortgage.

Why Save?
A key reason for saving is the point I just made--it is an important vehicle for accumulating wealth. But it also is important to save for financial uncertainties and retirement.

Saving provides some measure of financial security in case of a lost job or unexpected necessary expenditures, such as for uninsured medical treatment. Poor households do not appear to have adequate resources to cover unexpected financial crises. Most financial advisers suggest that households should have accumulated savings equal to six to nine months of income in order to be prepared for such crises. However, the typical low-income household has financial assets equal to only about two months of income, and the typical moderate-income household only to about three months of income. Moreover, about one-third of low-income households, and more than one-tenth of moderate-income households, report having no financial assets at all. These households are living from paycheck to paycheck with no financial cushion of their own for rough times.

An even more important reason to save is to prepare for retirement. An obvious question is how much retirement saving is enough? While the answer to this question differs depending on a family's financial circumstances, as a rule of thumb financial advisers estimate that it takes about 75 percent of a family's pre-retirement income to maintain its standard of living in retirement. Households can live at the same level with only 75 percent of pre-retirement income because of reductions in the typical family size, in payroll taxes owed, and in job-related expenses, such as commuting and clothing costs. In addition, when households pay off the mortgages on their homes, they can consume the same level of housing services with significantly less income.

For low- and moderate-income households, the news is mixed. On the one hand, Social Security alone replaces up to half of pre-retirement income for many low- and moderate-income families, bringing them about two-thirds of the way toward the 75 percent goal. In these cases, households must save enough to replace about 25 percent of their pre-retirement income. However, some low- and moderate-income households will have to save more than this because they had only intermittent spells of employment, which means that Social Security will not replace as much of their pre-retirement income.

Low- and moderate-income households' more tenuous attachment to employers is also a reason that they are less likely to be eligible for a pension. The SCF shows that more than half of all workers younger than sixty-five are covered by a pension from their job, but these rates of eligibility are much lower for households with below-average incomes. Only about 13 percent of workers in low-income households and about 25 percent of moderate-income households are eligible for pensions sponsored by their employers.

This evidence suggests that many low- and moderate-income households are not saving enough to accumulate the kind of retirement wealth that would allow them to maintain their pre-retirement standard of living. But while many households are not on track to accumulate adequate wealth for retirement, they are within striking distance if they change their behavior and begin to save. For example, the SCF indicates that low-income households typically have net worth equal to a little more than one-half of their income but will need to accumulate net worth of between one and one-fourth and three and one-half times their income by the time they retire in order to maintain their standard of living in retirement. Likewise, moderate-income households typically have net worth of about one and a half times their income, and will need to accumulate wealth of about one and three-fourths to three and one-half times their income wealth to reach their retirement savings goals. It is not easy for households struggling to pay bills every month to also set aside enough funds to ensure a reasonable degree of financial security during retirement.

But some important tax-preferred saving vehicles can help. One that has been available to all working households for the last twenty years is the individual retirement account (IRA). IRAs encourage saving by allowing tax-deductible contributions and tax-deferred accumulation of all returns on assets. With normal saving assets, the saving is not tax deductible and the returns are taxed as they are earned. With IRAs, taxes are postponed until the asset is cashed in, which means that the asset income accrues tax-free.

Despite this tax advantage, relatively few low- and moderate-income households make any contributions to IRAs. This low participation rate can be partly explained by the fact that households with modest means save very little in any form, and by the fact that the tax benefits of IRAs are not as large for those in low tax brackets. However, a lack of awareness of IRAs could also contribute to the low participation rate. To the extent that this is true, financial education could help increase awareness and promote saving.

A potentially even more important vehicle for retirement saving is the 401(k)-type pension plan. Such plans allow eligible workers to contribute to retirement accounts on a before-tax basis and receive tax-deferred accrual of asset returns, just as with IRAs. But unlike IRA contributions, 401(k) account contributions are often matched by the employer, providing a huge boost to retirement saving. Workers are eligible for 401(k) plans only if their employer sponsors one, and modest-wage workers are less likely than others to work for such employers. Nevertheless, eligibility for 401(k)-type plans has expanded over the past decade. Increases in eligibility were greater for higher-income workers, but eligibility among low-income workers also rose slightly from 9 percent in 1989 to 10 percent in 1998. Eligibility among moderate-income workers rose from 18 percent in 1989 to 21 percent in 1998.

While eligibility for 401(k) plans has increased among lower-income workers, participation is still low. Among workers who are eligible to participate in a 401(k) plan, lower-wage workers participate much less than higher-wage workers, and lower-wage workers who do participate contribute a smaller percentage of their income. This is a discouraging response to both the tax subsidy and the employer match. Because of these subsidies, participation in 401(k) plans by lower-wage households could significantly raise the wealth of households with modest means. It is time to redouble our efforts to promote saving for retirement by low- and moderate-income households through tax-advantaged savings plans that are available to them, such as IRAs and 401(k)s.

Financial Education
The low participation rates for 401(k)s and IRAs may appear to be something of a puzzle in light of the strong financial incentives they provide to encourage saving. The logical inference is that financial incentives alone are not enough to induce saving. People have to know about these programs, understand how they work, and understand their benefits to make sound financial decisions for their future. That is, education is a critical complement to financial incentives in promoting saving.

To the extent that inadequate savings are the result of a failure to recognize inherent economic risks, financial education can help supply the knowledge and specific skills required to plan for the future. Financial education can also provide the "how-to" knowledge needed to open a checking account or shop effectively for a mortgage. Indeed, there is compelling evidence that financial education matters. Recent research published in the Journal of Public Economics has found that high school students who received instruction on financial decisionmaking--including budgeting, credit management, and saving and investing--had significantly higher levels of wealth in adulthood than others.

Being a well-informed consumer also matters. Most people are aware that well-informed consumers can save significant amounts of money when buying big-ticket items like cars. But it is just as important to shop around for the best terms on a loan to finance the car. Unfortunately, this shopping around may take some effort and require some diligence in working through the fine print. For example, a credit card offer that arrives in the mail promising a 1 percent annual percentage rate should probably be scrutinized for the catch. Credit card solicitations should be evaluated and compared for interest rates, annual fees, and late charges.

Just as it is important to understand the terms of credit cards and household loans, it is also important to shop around for the best return on saving. Not all checking accounts are created equally, and it pays to shop around to find the account with the lowest fees and the highest interest rate. This advice also applies to the choice between opening a checking account and using check- cashing outlets to meet payment needs. Check-cashing outlets can be significantly more expensive than checking accounts at banks for the typical low-income household. Households that use check-cashing outlets to meet their payment needs spend up to three times as much per year to conduct their financial transactions as households that use checking accounts. Nevertheless, evidence from the SCF shows that 40 percent of low-income households did not have a checking account in 1998. We clearly have work to do to educate consumers about the actual costs of alternative ways to meet their cash management needs.

We at the Fed are dedicated to promoting financial literacy and making it easier for people to be smart consumers. To advance these goals, the Fed is represented on the board of the Jump Start Coalition, which seeks to encourage financial literacy among young adults by promoting the teaching of financial literacy courses in schools. The Fed also has issued regulations that make it easier for consumers to compare financial products. For example, truth-in-lending laws dictate that credit card companies must disclose the terms of the credit in plain and standard language. And there are special consumer protections for cases when homes are used as collateral for loans.

A significant aspect of being a smart consumer is being a smart borrower. As is well-known, predatory lending--lending on terms unfavorable to consumers and not fully understood by consumers--has lately become a growing problem. The problem is not high interest rates as such; the problem arises when consumers do not understand the full implications of high interest rates and other loan terms. The Fed has conducted four hearings on predatory lending, and has proposed regulatory changes that tighten some restrictions. With our twelve Reserve Banks, we have also produced a number of articles, brochures, videotapes, and web sites to promote understanding and combat undesirable lending practices. The goal is to help people become informed borrowers, informed consumers, and informed savers.

Conclusion
Overall, there is some good news and some bad news about the saving habits of low- and moderate-income households. On the bad side, low- and moderate-income households have less wealth, and benefit from capital gains, than do other households. On the good side, low- and moderate-income saving and wealth-owning rates are picking up, and low-income households are beginning to participate in the wealth-building process that has dramatically improved the lot of other Americans. Also on the plus side, low- and moderate-income families are beginning to use the many available tax and employer subsidized outlets for saving.

Looking ahead, perhaps the biggest challenge is educating people to be better consumers, savers, and borrowers. The financial literacy challenge is huge, but so is the potential payoff.